Consumer inflation could be highest in more than six years, but still not too hot

Core consumer inflation, excluding food and energy, was expected to rise at a 0.2 percent pace in July, or a 2.3 percent year-over-year pace, according to Thomson Reuters.

Headline CPI, including food and energy, could also have reached a 3 percent year-over-year pace for the first time since December, 2011, with apparel and lodging two areas that could have seen prices rise in July.

Economists are watching the inflation data for any impact from trade wars, but they say it is likely too soon to see any pass through.

Consumer inflation could have risen at a 3 percent year-over-year pace for the first time in more than six years, with prices for apparel and lodging picking up in July, according to economists.

With the economy growing above its recent trend at 4.1 percent last quarter and the job market solid, inflation is the data that has become the wild card. It is the most closely watched by markets, since it could affect whether the Fed speeds up or slows down its interest rate hikes, and rates affect everything from economic activity to asset values.

Economists are debating whether the trend in inflation is pointing to a pick up or not, and they are also watching the 8:30 a.m. ET report Friday for signs the trade tariffs have affected prices.

Economists expect core CPI, excluding food and energy, to be up just 0.2 percent in July, a 2.3 percent year-over-year gain, matching June's pace. Headline CPI, including food and energy, was last at 3 percent in December, 2011. The Fed has a target of 2 percent for inflation, but it more closely watches the core PCE inflation data, which has been just below its target.

"It does seem like we are on a better trend for inflation. Our expectations going forward is inflation tends to gradually trend higher, just a continuation of the momentum going forward," said Alex Lin, U.S. economist at Bank of America Merrill Lynch. He expects a 0.2 percent gain in core CPI.

But that is not a view shared by everyone. Ward McCarthy, chief financial economist at Jefferies, sees just a 0.1 percent gain in core and headline inflation. "Core commodities prices have responded very poorly to all of the trade war threats," he said. He said a factor that could impact the headline CPI was a bigger than normal decline in gasoline prices for this time of year.

"It's a high probability it's a high water mark for inflation this year. The primary reason is base affects," he said. "The tariff situation makes the inflation situation murky for the rest of the year. So far the bigger picture has been commodity markets are pricing in slower Chinese GDP."

"The inflation picture is pretty difficult to decipher at this point," he said, adding lower commodity prices could signal a trend of disinflation.

The trade battles could also drive prices higher, if companies are able to pass through higher prices, but economists do not expect that yet.

Stephen Stanley, chief economist at Amherst Pierpont, said he expects inflation to keep rising, and his forecast is for an above consensus 2.4 percent year over year increase in core CPI.

"We're seeing core numbers that are likely to be at the highest they've been since 2008...More and more firms are talking about raising prices," he said. Stanely said some companies are pointing to rising input, but others may believe the economy is strong enough to support price increases.

"Anytime you see input costs increase, whether it's pass through or not is to a significant degree a function of the strength of the economy," he said. "If a firm feels good about the robustness of the economy, they're more likely to push through price increases and having a narrative around that is helpful. Being able to say 'it's tariffs' gives you a valid reason to raise prices."

But he said the steel and aluminum tariffs have not been in place long enough to show up in the data, and other tariffs on $34 billion in Chinese goods just took effect in July, with tariffs on $16 billion more due in August.

Stanley said he is particularly watching price changes in the categories of airfares, apparel, used and new cars and hotel rates. Collectively, those categories were responsible for a decline of 0.4 percentage points in June's CPI and are categories that are often "noisy," he said.

Lin said he is especially watching apparel and lodging for a snap back from June.

"Apparel prices saw a notable decline last month, and it's likely we do see a payback," he said. He also said the lodging away from home category inexplicably declined a record 3.7 percent month over month. He also expects a rebound there.

Economists said the July CPI report will not make much difference for the Fed, but markets could react if it's hotter or much cooler than expected.

"They're looking to see if we can sustain 2 percent because it took so long to get there. They're a little bit hesitant to declare victory prematurely. They want to see us sustain that 2 percent level," Stanley said.